Euro in 'trend change,' as dollar gets thumped on US political risk, lowered Fed expectations

The euro has been rising on relief about the French election and the improved European economy.

At the same time, the dollar is weakening on amid heightened political concerns and a recent batch of disappointing U.S. economic data. The dollar index is at its lowest level since November's election.

Stocks were sharply lower and investors moved into bonds Wednesday as controversy in Washington raised concerns that the Trump agenda of tax reform and fiscal stimulus will be slowed down. The latest uproar was over reports that President Donald Trump asked former FBI Director James Comey to end his investigation into former national security advisor Michael Flynn.

"I think it's a 'risk-on, risk-off' pivot story. That's where we've gone in the last 24 hours," said Dan Katzive, head of foreign exchange strategy, North America, at BNP Paribas. "It's a trend of the dollar weakening against current account surplus currencies like the euro and yen."

Katzive and other strategists say doubts about whether the Fed can raise rates two more times this year have also been a factor weighing on the dollar. "It's mainly a monetary policy driven story, and whether the financial market distress, if it continues to pick up, will derail that story," he said. The Fed has forecast two more interest rate hikes by year-end but the fed funds futures market reflects expectations for just one full rate increase.

The dollar has become a play on reflation, and its decline is linked to that, Katzive said. "It's a combination of the data surprises continue to weaken and the political noise as well," he said, adding he's still bullish on the dollar and expects it to stabilize and recover.

The dollar index, based on a basket of currencies, fell below 98 on Wednesday, its lowest level since before the November election, and much of that move had to do with gains in the euro. The greenback surged after the election of Trump, whose fiscal and tax policy was seen as a boon for the U.S. economy, but now there is uncertainty around the timing of legislation on those policies.

The dollar's move Tuesday and Wednesday, in fact, was also attributed in part to greater uncertainty coming out of Washington. The currency moved lower Tuesday after a report that Trump revealed classified information to Russia and again Wednesday, after it was reported that the president asked Comey to end his investigation into Flynn.

Strategists say it's not clear whether there will be lingering repercussions for markets, but the market is sensitive to anything viewed as being potentially disruptive to the efforts of the White House and Congress to work on tax reform.

"It's mostly a euro trend change that's going on. We really broke down in 2014, 2015. It went to 1.40. When the [European Central Bank] started going to negative rates, we had a move to 1.05 and we've been consolidating around there for two years," said Jens Nordvig, CEO of Exante Data.

Nordvig said the flows into the euro are significant, and his next target is 1.15 against the dollar.

"Momentum can be very powerful," said Thanos Vamvakidis, head of global G-10 foreign exchange strategy at Bank of America Merrill Lynch.

"Many people were surprised the euro did not appreciate more after the French election," he said. "Last week, we saw the strongest flows into equities ever. ... All the markets were expecting Macron to win. Still, when it happened, it was bullish for markets."

Emmanuel Macron won the French election by a wide margin over Marine Le Pen, a far-right candidate who opposed France's participation in the euro.

Vamvakidis, however, does not see a big move higher for the euro, and his year-end target is 1.08.

Brown Brothers Harriman analysts do see upside for the euro, and see a next upside target for the euro against the dollar at 1.15.

"It really depends on what happens with the U.S. data and on the fiscal side. Unless something changes, the path of least resistance is higher for the euro," said Win Thin, senior currency strategist at Brown Brothers Harriman.

Vamvakidis said his outlook for the euro is mixed because the Fed is expected to raise interest rates, which would drive the dollar higher. But the U.S., along with the U.K., has had the most negative economic surprises of any economy, while Europe has had the most positive economic surprises.

"The European data has been improving for most of this year. This clearly increases the chances the ECB will announce tapering QE [quantitative easing] in the next few months, most likely September," he said. That would put the ECB on track to pull back on easing, just as the Fed is expected to hike rates in September.

"We have been saying the euro-dollar outlook is mixed because of what we think about the next few months. It does depend if the Fed hikes rates in June or September or December. When are they going to start unwinding the balance sheet?" said Vamvakidis.